Weekly Spread Re-Cap

A few spreads in our book made sharp movements this week.  The first, 4*GLD – 9*GDX, closed last week at 13.80. Yesterday afternoon it traded in the high 30’s.  We like to trade whenever we see such a large move, especially given the fact that very little has changed economically in the past week to justify such a jump in the price.  Additionally, the spread looked rich relative to its six month average price of 13.15.  We sold a small amount at 37, leaving room to add more if it went against us.  This morning it briefly traded at about 43 before drifting down to 32 at the time of this writing.  We will look to unwind in the mid 20’s.

Two other spreads worth noting are 5*USO- 3*XLE and 3*USO- 2*XOP.  Unlike GLD-GDX these spreads do not fluctuate wildly in such short periods of time.  They tend to move in one direction for long periods.  We’ve been long both of these for a few months now and have watched them slowly move against us.  That recently changed.  Both spreads bottomed on Feb. 16^th, with USO-XLE closing at -50.20 and USO-XOP closing at -12.15.  These spreads sharply reversed direction at the beginning of the recent turmoil in the Middle East, and as of the time of this writing are trading at -23.15 and 4.30, respectively.  Today they are down for the first time in over a week, which may be a buying opportunity.

Written for Bigger Capital by Norm Winer on 3/11/2011. Follow me on Twitter and StockTwits

The Trading Books I Want to Read…

Have the following things in common. They:

• Are written by someone who made a load of money.
• Contain one or two powerful ideas.
• Should be no longer than thirty pages. Let’s stop the yapping.
• Are published in electronic format.
• Are self-published so that text to speech and other innovations are not restricted by the publishers.
• Welcome the readers to initiate a discussion with the author.
• Are written by an author who is responsive to his or her readers.

What kind of trading books do you want to read? Chime in.

Michael Bigger. Follow me on Twitter and StockTwits.

The Creative Space

At Bigger Capital’s we recently started building our Creative Space. What is the Creative Space? A Creative Space is your augmented information space.

In my new book How Traders Achieve Creative Flow, I describe my information space the following way:

The process of extracting intelligent information is creative. Using creativity, I apply a framework to recognize, harness, and interpret information and continuously evaluate the quality of the information. This defines the Internet information space in which I operate. That space is my creative ecosystem (see chapter 11, “Building a Creative Ecosystem”). I challenge myself continuously to use that creative space to interact with other very smart traders to promote the collision, fusion, and combination of ideas. Think of it as a massive dam extracting energy from a flowing river. The creative ecosystem is the turbine transforming that intelligent energy into powerful trading insights—insights you can use to innovate your trading edge and to increase your value to infinity. This ultimate experience results from achieving creative flow, which we will discuss in chapter 2.

The Creative Space is that information space augmented with the following concepts:

• Network augmentation capital empowerment.
• Location independent brain power extraction.
• Brain synchronization.
• Development of digital second selves.
• Brain augmentation using technology.
• The algorithm as the Creative Space and vice versa.
• Neurons and Humans APIs.
• Twitter as the brain synchronization API.
• Mechanical Turks as traders.
• Brain power elevation.
• And so forth.

I will explore each of these concepts in future blog posts.

Michael Bigger. Follow me on Twitter and StockTwits.

You Were Wrong Buying SPX at 777

You were wrong as you watched it slide to 666 in early 2009. But wait, the market has since rendered its verdict, and now you know you were right.

How could you be both right and wrong about one decision you made in the past? Your mind tricked you. You most likely attached too much importance to what was happening then. You let the market, which at the time was composed mostly of people going apeshit, lead you into drawing a hasty conclusion.

Humans have a tendency to attach too much importance to recent events. This cognitive dissonance is known as the fallacy of vividness.

People going apeshit are lambs. They sell low, they buy high, and they compound their assets into negative returns.

Do you hear the lambs approaching?

Michael Bigger. Follow me on Twitter and StockTwits.

P.S. Check out my new book How Traders Achieve Creative Flow.

Renita T. Kalhorn, who contributed the bonus work to the book, sent me the following comment this weekend:

Hi Michael,

I read your book again over the weekend and felt like I was reading it for the first time! It truly is chockfull of profound and practical insights. I hope you will send it to Seth Godin — I’m sure he would be interested in learning how you’ve applied some of his ideas.

I also think your diagram of the creative ecosystem is very powerful/useful, and something that traders should keep in front of them at work. You could have someone flesh it out artistically, kind of like a mind map, and even make it a separate download, like behavior gap does with his drawings.

How Traders Achieve Creative Flow Interview

Renita T. Kalhorn, who generously contributed the bonus material for my book titled How Traders Achieve Creative Flow, interviewed me last evening. You can listen to the interview right here.

Michael Bigger. Follow me on Twitter and StockTwits.

The Creative Trader Manifesto

Dear Trader,

To celebrate my recently published book titled How Traders Achieve Creative Flow, I have created The Creative Trader Manifesto for you for free. You can download a PDF version of it by clicking here. If you like the material, pass it on to another trader.

Renita T. Kelhorn, who generously contributed the bonus material to the book, will be interviewing me this Thursday at 5pm. To listen in, register here.

Michael Bigger. Follow me on Twitter and StockTwits.

How Traders Achieve Creative Flow, an Interview With Veteran Trader Michael Bigger

Information is abundant and technology is cheap. At the same time, the good ‘ol financial models are changing. Linear, analytical thinking is not enough, and traders who don’t figure out how to access their creativity will fall behind.

Listen in on this free teleseminar as I speak with veteran trader and author Michael Bigger about his latest book, How Traders Achieve Creative Flow. Here are a few of the things you’ll learn in this 30-minute call:

- Why creative flow is so imperative to staying competitive
- The one tool you need to implement to avoid being drowned in information
- How Seth Godin and other unlikely influences have inspired Michael’s winning trading decisions
- How to avoid the mistakes that mediocre traders make

It’s going to be a short, information-packed call. Register right here (you’ll receive dial-in info the day before):

Online Ticketing for [TELESEMINAR] How Traders Achieve Creative Flow powered by Eventbrite

More about Learning Spread Trades

Written by Norm Winer. Follow me on Twitter and StockTwits.

Norm trades spreads for Bigger Capital. Norm comments on Chris Cachat's post about spread trades follow:

We enjoyed your post on spread trading.  It’s nice to hear we inspired you to learn more about spreads, and it’s always helpful to hear how other traders approach things.

Reading your post, I see you are grappling with some of the same issues we did, and still are, and we thought we’d share some of our thoughts and experiences with you (and by we, I mean @biggercapital, @biggercapitalnw, and @fledlingtrader, who collaborates with us on trades).

It looks like you are basing your calculations on a 30 day time period.  We have found that, while that approach works well with some spreads such as GLD-GDX, it often pays to look at longer time periods as well.  We are now experimenting with looking at Cointegration and Z scores (standard deviations from the mean) based on five years, two years, one year and sometimes six months of data.  We have found that something that looks cheap over a 90 day period, or even a two year period, can look a little bit pricey over a five year period.  Just look at where NFX-BRY was trading a week ago and where it’s trading today.

Regarding when to unwind or when to cut, we only recently started giving serious thought to this.  Because we prefer to unwind quickly also, we have probably been cutting winners too early.  We are now paying closer attention to whether a spread still looks cheap or expensive before we unwind, even if we have already made a good return.

Lastly, definitely look more closely at half-life, especially if you’d rather not hold positions for long periods.  Good luck and let us know if you discover anything interesting!

P.S. Micheal's book How Traders Achieve Creative Flow is now available on Amazon.com. If you want to use your creativity to innovate your trading edge, this book is for you.

Learning Spread Trades

This is a guest post about spread trades written by Chris Cachat. Follow me on Twitter and StockTwits.

First off, I barely know what I'm doing here. I had never really thought about spread trades until I began following Michael Bigger (@biggercapital). The guy really seems to have a passion for spreads, and it's kind of contagious. Credit is also due to Aris David (@fledglingtrader) and @biggercapitalnw for posting some spread trades for me to study. Dynamic Hedge is really good with these too, so I thank him for some education too.

The spread I'm looking at is UNH - WLP. Below is a graph of the spread. I'll explain further.

Click image to enlarge.

The top graph is the price of UNH 42.59 / WLP 67.21 = 0.63.
Red line = 30 day linear regression line
Blue dotted line = 2 standard deviations away from the red line
Fuchsia line = 3 standard deviations away from the red line

The bottom graph is simply the price of a dollar neutral (almost) spread: 12*UNH - 7*WLP [Long 12 shares UNH, short 7 shares WLP]. I need this bottom chart so I can analyze the actual prices of my desired spread.

Reasons for Identifying this Spread

1. Both stocks are in the same industry
2. They are highly correlated 96.45% over the last year. Correlation = A statistical measure of how two securities move in relation to each other.
3. They are highly co-integrated 99.50%. Cointegration = the statistical confidence that a pair will revert to the mean. I think cointegration is the most important. High correlation means that over a given period of time, two stocks will move up or down in synchrony. But high cointegration means the two prices cannot wander too far off in opposite directions for very long before they eventually come back to a mean distance. Unfortunately, my Amibroker cannot calculate cointegration, so I rely of this nifty website Catalyst Corner. I run a trade report (see bottom of post) that confirms some of the things I'm reading on the charts.
4. It is over two standard deviations away from it's 30 day linear regression line. You can see at the beginning of 2011 the spread touched the bottom 3 STD line, then snapped back. It hit the upper range then came down to where it is today. I'm expecting similar action.
5. WLP is short term overbought in my book, RSI(2)>99.

Using Interactive Brokers, you can create the 12*UNH - 7*WLP spread and enter a limit order; they handle the price execution on each stock. That spread closed at 40.63 today, so I might place a limit order below that. I would be buying a price that is statistically very far from it's mean, and likely to revert back.

Exit Strategy

I'm still trying to figure this part out, but I think I'll look to exit when the spread price gets back to it's 30 day regression line, which it $53. I don't know though; I may just use discretion. I'm treating this as a short term trade, so I'd like to get out in a few days.

UNH and WLP are slow movers and I don't really expect fast action, so I think they're good to learn on. When I get more comfort with spreads, I'll look to more volatile stocks. They're not even going to make me big $$, but that's OK. If I got in at $40 and exited at $53, buying/selling $10K of each stock, it would be about $260 profit.

Difficulties I've Encountered

Finding trades on a daily basis! I wish I could just write a code in Amibroker that would scan stocks and give me the spread ideas. I can't though. I think I need to just pick a few spreads that are highly coointegrated and watch them all the time. I'd look for similar scenarios I see with UNH - WLP.

Backtesting - I haven't figured out how to code this in Amibroker. Being a quant (albeit Simple), I feel more comfortable making trades that have some backtested results. I need to work I my coding skills, but in the meantime, I'll really on my human brain and real time trades to figure this out.

Why I'm Trying These

To do something new and expand my trading repertoire. If I can sprinkle a spread strategy with my other strategies, it can benefit my bottom line.

Most importantly, I view a spread trade differently that just a regular 'go Long' or 'go Short trade'. Sure, I want UNH to go up and WLP to go down; that would be ideal. But the way I really look at it: I want UNH to go up faster than WLP or I want WLP to go down faster than UNH. I'm not trying to be green on each stock, just green on the spread. So I'll probably have one winner and one loser, but overall net positive. Also, there's less anxiety about market direction.

So there it is. This spread stuff is a work in progress. I'm just glad I found some cool people in twitterland that introduced me to the idea. I know I'm not considering many factors like half life or Pearson correlation, but in due time. Let me know if I am on the right track.

Cheers!

This is the Catalyst Corner report, click to enlarge

Click image to enlarge.

Freedom to Trade

This is a guest post about flow written by Eric Gong. Follow me on Twitter and StockTwits.

If you’ve never jumped off a cliff, I highly recommend that you try it.

Don't take me seriously, of course. What I mean is cliff diving into the ocean—giving yourself completely to gravity. I want to share this experience with you as it relates to success in trading. I got married in Hawaii in September 2009, which was six months after I began my trading career. So both literally and figuratively, I was jumping off many cliffs, giving myself to whatever was to come.

The experience of jumping off a cliff and into the ocean gave me a sense of freedom that I had never felt in my life before. Only when your pinky toe leaves the rock do you truly realize what you have gotten yourself into. Gravity will take your little body and slam it against the water. The air will slap you across the face every single millisecond of the way down, and there's nothing you can do about it.

That's the beauty of the experience.

As traders, we are always planning and controlling how to manage entries and exits to maximize profits. When positions go against us, we get mad and blame the markets. We blame high frequency programs, the specialists, the government, or the trader next to us who has this annoying habit of tapping the desk when we're in a losing trade. So much about the markets is uncontrollable, and we spend so much time trying to rationalize and control it. What if we gave in to the markets? What if we leapt off the proverbial cliff and let the market take us over? What if we spent more time in that moment when our pinky toe leaves the rock?

I experienced that exact feeling once again trading the stock market last week, and it changed my trading forever. I sat at my trading desk with flow that I have not felt in years—a feeling I have only encountered once while jumping off those cliffs in Hawaii. The thing that changed for me was that I finally accepted the market for what it is: a continuous series of uncontrollable interactions between buyers and sellers. During that trading day, as my proverbial pinky toe left that rock, I felt freedom—freedom that only acceptance can bring. As I bought stock, I gave in to the fact that it could go anywhere and that the only thing I could control was my risk. As my profit and loss monitor fluctuated back and forth from red to green, I accepted it as the nature of trading. As I was maxing out my buying power, I accepted the fact that although these trades were the perfect execution of my plan, anything could happen at any given time. I realized that this was the gravity of trading, and I would not spend my days trying to manipulate it; instead, I would accept it.

If my positions went in my direction, I stayed patient until the charts let me know when to release. If my positions were stale, I'd reduce or remove my risk. At the end of that trading day, I felt as if my body hit the water. The experience giving in to the market was the best experience I ever had trading. As I stared at the results from my day trading and swing trading accounts, it became the high watermark of my entire trading career.

Freedom is why I got into the business of trading, and the flow that I am feeling lately is like diving off a cliff in Maui.